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Why Tesla Motors' Silicon Valley Playbook May Be Outdated

Tesla Motors operates like a Silicon Valley tech company, but it's entering markets that don't look like tech at all.

Silicon Valley is the home of some of the biggest tech companies in the world and the area's engineers and investors have used some fairly similar strategies to dominate their respective industries. If you look at the largest Silicon Valley success stories they serve what may be considered to be a two-sided market with a high probability of network effects that keep competitors at bay. As a result, the businesses require rapid growth in order to capture market share, and once you get that market share the profits start pouring in.

Apple, Google, Facebook, Uber, Snapchat, Microsoft, Amazon.com, Intel, and Oracle are just a few of the tech companies that have exploited the near monopoly power a two-sided market can provide to build massive businesses. This is the context under which Elon Musk got his start in business and are some of the dynamics that made Paypal such a success. Now, with its Gigafactory 1, Model 3 production plans, and solar investments, it looks like Tesla Motors(NASDAQ:TSLA) is treating energy a lot like Silicon Valley neighbors with a "grow at all cost" mentality. But are cars, energy storage, and solar panels at all similar to building a software company in Silicon Valley?

The power of two-sided markets

Before we dive too far into Tesla's strategy, I think it's important to look at how two-sided markets and the network effect have been used in Silicon Valley. In a two-sided market, a company is bringing some value to one group of people (usually consumers) and another value to another separate group of people (usually suppliers), creating value for both. Having more customers brings more suppliers, which makes the market more attractive to customers, which brings more suppliers, and so on. That's the network effect. Once both groups of people start using the company's services it's often very difficult to leave, which is why companies with a dominant market share can become so valuable.

Apple's iPhone is a great example of this dynamic at work. As people bought iPhones it created a large market for developers to build apps and sell them to customers. More apps made iPhones more attractive than competing products and led to more iPhone sales. Eventually, millions of customers and developers were locked in. Today, even if Blackberry introduced a phone that was better than the iPhone it wouldn't have the developer infrastructure or the user base to be an attractive platform, making it very difficult for either consumers or developers to leave iPhone for Blackberry.

Musk's first major success, Paypal, used the same concept. Once consumers had Paypal accounts it made it attractive for both other consumers to get Paypal and for businesses to accept Paypal in their own payment systems. And growth in users led to growth in businesses using Paypal, leading to a virtuous cycle.

Every company I mentioned above serves a two-sided market in one way or another, benefiting from the network affect the market can provide. A key to the success of each of them was rapid growth to take a vast majority of their potential market before competitors could catch up, and once they dominate the market they're the de facto standard. It's why Uber fights Lyft so intensely and why Amazon is willing to lose money just to take share against online retail rivals. They all want to be the standard in the market.

The question is: Does this typical Silicon Valley playbook work for Tesla Motors?

How Tesla Motors is starting to look like Silicon Valley neighbors

The way that Musk has been building out Tesla Motors' capabilities as well as its partnerships is a lot like a tech company in a two-sided market. He's trying to grow Tesla Motors and SolarCity(NASDAQ:SCTY) as quickly as possible, taking as much market share as possible. The more capabilities he can offer to customers the more they'll buy. An electric vehicle turns into a solar-power system, which may eventually turn into a Powerwall or even a solar roof.

Image source: Tesla Motors.

From the supplier side, Musk has tried to standardize his own products. In EVs, he opened up all of Tesla Motors' patents, not out of the goodness of his heart, but because he wanted competitors to start using Tesla's proprietary charging plug design. If he could get others to use Tesla technology it could start controlling the charging network.

He's dismissed the hydrogen technology Toyota(NYSE:TM) and Honda(NYSE:HMC) are working on as "incredibly dumb." If electricity is the standard, Tesla Motors will be a big winner.

In solar, SolarCity bought ZepSolar just as it was becoming the standard racking design for the industry. And it tried to take so much market share that competitors were effectively squeezed out of the market out of a lack of scale.

Energy storage may be where the real vision of a network effect is being built. If Tesla Motors acquires SolarCity and energy storage becomes a standard offering with solar and EVs, utilities will become the partner on the other side of the market from consumers. Musk would control when energy storage systems are charged and discharged, which would make Tesla a key partner to utilities along with being a supplier of batteries to the utility itself. Utilities may not be willing partners with Tesla, but they would be forced to be partners if the company has enough batteries and EVs in the market.

Where the network effect falls apart for Tesla Motors

The idea of Tesla Motors being at the center of a two-sided market may look good on paper, but in practice it won't work anything like a typical tech company.

I don't think customers are more likely to buy a solar-power system from Tesla just because they bought an EV from them and energy storage won't be a guaranteed add-on. The goal of standardizing EV or solar designs has failed because no major automaker is using Tesla plugs and solar components are easy to swap out.

Competing technology like hydrogen will also compete on its own and may be in adjacent markets, not the EVs or battery energy storage Musk is building today. Trucks are already being developed with hydrogen/electric powertrains and competitors are launching hydrogen cars.

Most importantly, energy is a highly regulated market, unlike computer operating systems, ride sharing networks, or social media. For Tesla to compete in solar and energy storage it will have to compete on a level playing field with other companies in the same business. Scale could help, but there will be no locking out competitors because regulators will demand transparent bidding on services. And that could derail how Musk is looking at being a central player in the tie between consumers and suppliers in the energy market.

Tesla's products may not have a Silicon Valley advantage

At the end of the day, Tesla Motors' products will likely have to stand on their own against the competition, without a the competitive advantages two-sided markets have brought to much of Silicon Valley. That'll make competition a lot more fierce and could make it harder to make a profit as a result. That's something to keep in mind when investors are cheering Tesla Motors' grow at all costs strategy.

Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Travis Hoium owns shares of Apple, Intel, and PayPal Holdings. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), Amazon.com, Apple, Facebook, PayPal Holdings, SolarCity, and Tesla Motors. The Motley Fool owns shares of Microsoft and Oracle and has the following options: long January 2018 $90 calls on Apple and short January 2018 $95 calls on Apple. The Motley Fool recommends Intel. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.